Friday 27 April 2018

An average Mr Trichet was a large part of the eurozone problem

Today, Jean-Claude Trichet chairs his last meeting of the Governing Council of the ECB. The session will be held in Berlin to underscore a sense of occasion and Mr Trichet will, no doubt, be lauded for his eight years of service to the central bank.

The reality, of course, is that the eurozone is on the verge of collapse and that Mr Trichet's successor, Mario Draghi of Italy, has a very difficult job ahead.

The most immediate decision facing the Governing Council is when to reverse a series of interest-rate hikes that began in April.

There have been no further increases since July but it is ever more obvious that the hikes must be overturned in support of a flagging euro economy.

The decision may be delayed until next month, to save Mr Trichet's blushes, because it is the second time in three years that the ECB will be forced into an about-face.

ECB rates

In mid-2008, the ECB raised rates in the teeth of an emerging crisis in the United States, only to slash them again when Lehman Brothers collapsed in September.

On both of these occasions, the US Federal Reserve adopted a low-interest-rate path from the start and was proven right. On both occasions, the ECB failed to appreciate the magnitude of the coming storm and had to quickly change course.

Mistakes like this make markets very nervous and undermine credibility in the ECB as an institution. And two German members of the ECB board have quit.

The ECB's reputation is very low and it is increasingly obvious that its approach to the euro crisis is flawed.

Many have begun to ask whether the common currency could ever have worked and, accordingly, the sacrifices they are willing to make for its survival are waning.

The ECB is still unwilling to admit to any errors. But its blunders must be exposed if the euro is to recover. The central and repeated mistake Trichet made was to confuse the average economic health of the eurozone with the well-being of the whole.

He assumed that stable growth in the larger economies would, somehow, help to overcome any problems in the smaller economies and that, therefore, policy should be directed toward what was appropriate for the larger economies.

This is why, for example, he twice embarked on an early lowering of interest rates -- and didn't see the dangers.

Mr Trichet failed to realise the eurozone is only as healthy as its most-exposed members and that policy should be concerned with them.

This led to three crucial mistakes that defined the crisis.

Debt

First, during the boom of 2004-07, the economies on the periphery were growing too quickly and accumulating too much debt.

The ECB weighed this against sluggish growth in the core and assumed that policy was, on average, appropriate. In reality, however, the periphery was acting like a burst pipe that had become the outlet for a general build-up of pressure in the system.

The pressure needed to be relieved through a general tightening of monetary policy but was, instead, released in localised booms.

Then, when the crisis hit, the ECB sought to contain the problem in the periphery -- by forbidding default on bank or sovereign bonds -- and pretend that the rest of the zone was healthy. Again, we were told that the eurozone was -- on the whole -- better than the US: its banking system had adequate capital, on average, even if the peripheral economies (and their banks) were being crucified.

Ever still, and despite the dangers, Mr Trichet could not resist the allure of the average and -- in stage three -- started to raise interest rates again when the larger economies showed any sign of growth.

But a debt burden that was generated from the entire euro system was just too big to place on a few small economies and these had already begun to crumble -- even before they were hit with higher rates.

The euro debt burden is now rapidly heading back into the core via its vulnerable banking system. Mr Trichet's delusion that the banks are healthy has been exposed and euro finance ministers are, at the last minute, scrambling to prepare them for the inevitable defaults on sovereign and other bonds.

The eurozone is composed of 17 very disparate economies and there are severe limits to the amount of assistance they will provide to one another.

This has become very clear from their grudging response to the crisis and it is completely futile to call for unrealistic treaty changes and fiscal union at this stage.

Mr Trichet knows this -- he was a leading architect of the Maastricht Treaty -- and his recent calls for such a "solution" are intended to divert attention from his own misreading of the crisis.

The biggest task facing Mr Draghi is to re-establish credibility in the ECB. This will be a long process but must start with recognising mistakes.

Mr Draghi must point to the dangers of being fooled by averages and strongly support eurozone members as they shore up banks across the board.

Ireland could have done with such support.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and has advised numerous governments on macroeconomic policies.

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